The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Thursday, September 27, 2012

Bank of England's Robert Jenkins takes on the Blob

In a forward to an interesting book, The Making of Good Financial Regulation, the Bank of England Financial Policy Committee member Robert Jenkins takes on the Blob (aka, politicians, the regulators, Wall Street and its lobbyists).

Specifically, he looks at the problem of regulatory capture by the financial industry.

Driven by hubris, greed and stupidity bankers led the charge off the cliff. But where were the regulators?
Why did they not see it coming? Why did they not prevent it? Why did they trust bankers to know what was
best for banking? In short, how could regulators have been so dumb as to believe that bankers were so
smart? ....

Excellent questions.

Industry influence operates at all levels of the rule making ranks – from the peak of politics to the substrata of
supervision.

This was first confirmed by the Nyberg Report on the Irish Banking Crisis.

The report concluded that industry influence at the peak of politics undermined and would always undermine the regulatory process. When everything appears to be going well, no politician wants to hear from a regulator that a potential problem is brewing.

The report also conclude that industry influence with the regulator at the substrata of supervision undermined the supervisory process. Even if the examiners uncover problems at a bank, they have to convince politically appointed superiors who talk to the banks that they are right.

Regular readers know that the only way around this industry influence is to require banks to provide ultra transparency and disclose on an ongoing basis all of their current global asset, liability and off-balance sheet exposure details.

With this information, market participants can independently assess each bank and not rely on the regulators.

With this assessment, market participants can exert discipline on the banks and not rely on the regulators.

It need not be unhealthy. Indeed, interaction between regulators and the regulated is natural
and normal. Yes, industry seeks to shape the rules under which it will operate. But rule-makers need industry
input in order to craft sensible policy. Some degree of influence is therefore inevitable.

Based on the Bank of England's Andrew Haldane's argument for simplicity, there should be a lot less rule making.

One of the benefits of requiring ultra transparency is that it limits both the number of and complexity of rules needed to shape industry behavior and restrain risk taking.

Unfortunately, there
are times and industries where special interest groups are able to bring disproportionate influence to bear – a
condition called “regulatory capture.” The financial sector is one such industry and the run-up to the crisis
one such time. The obvious question which arises: is such influence still excessive and thus unduly shaping
the needed regulatory response?

My first encounter with “capture” came at a moment of meltdown in 2008. At the time I chaired both a
London-based investment firm and the trade association representing the UK investment industry.

As
financial panic spread I watched in disbelief as bankers trooped through the doors of Downing Street to
advise Government on how best to address a problem which bankers themselves had largely created.

Far
from being discredited, the guidance of these “experts” was eagerly sought – and with virtually no
counterbalancing input from other stakeholder groups. ... But at that key moment in time - capture was complete.

“Political capture” can be fueled by campaign contributions but in the case above, it resulted from the
pervasive beliefs of the day.

The theology of the time maintained that: markets were efficient and would
provide the necessary discipline to participants; the financial sector could be left largely to police itself; global
banking and their host centers were engaged in fierce global competition; regulation should facilitate that
competition and not get in its way; and therefore, when it came to regulation, less was more.

This set of
beliefs permeated the body politic, shaped the regulatory approach of “light touch” and, believe it or not,
established a mindset amongst some supervisors that the regulated banks were to be seen as “clients.” The
technical term here is “cognitive or intellectual” capture. The non-technical term is brainwashed.

Please re-read the highlighted text as I shared Mr. Jenkins' disbelief when watching the bankers who created the mess advising governments on how they should respond.

My disbelief has only grown over time as I have watched a parade of economists who did not predict the financial crisis offering their advice to governments on how they should respond.

It is not surprising that neither the bankers or the economists have managed to end the financial crisis. Nor is it surprising that

Four years on, one might imagine that bankers’ ability to bewitch and bamboozle would have ebbed. Alas
not.

Their formidable lobby has led and continues to lead an effective campaign to persuade pundits, public
and politicians that calls for higher capital requirements are impeding the economic recovery. It is an
argument framed so as to force the gullible and well intentioned to choose between public safety and
economic growth. It is a false argument and a false choice....

Their formidable lobby has done a lot more than that. For example, it wrote the bulk of the Dodd-Frank Act with the exception of the Volcker Rule and the Consumer Financial Protection Bureau.

The objective of the author, as indeed
that of its sponsoring publisher, is the making of better regulation. What therefore, could be more timely than
an analysis of a key impediment to effective rule making and supervision?...

The recommendations in this volume are
presented as actionable “low hanging fruit” – which they are, provided excessive industry influence does not
prevent their adoption.

As Duke Law School Professor Lawrence Baxter observed on page 37

Various tools and techniques exist or have been proposed for promoting a proper balance [between banking and regulators]. Sunlight through transparency – that Brandeisian ‘best of disinfectants’- remains as sound as ever.

Bankers resist transparency for various reasons. They are practised in strictly protecting client confidentiality and they do not want to share information that might be useful to competitors. Together with central bankers they also fear that disclosure would reveal financial institution dependence on liquidity supports, and that this knowledge would be misunderstood by the markets and lead to runs on institutions and perhaps even to general financial instability.

These arguments against transparency are dubious.

Mythological actually.

The first – protecting client confidentiality – is usually not endangered when detailed but anonymized bank information is disclosed, and if a client position is so large that it would be recognized this information is usually known to the market anyway.

The second – protecting information from competitors – is no more important than in any other industry,so it is unclear why banks should enjoy a special privilege in this regard.

And the third – protecting the market from misunderstanding the liquidity needs of banks – seems really to have ended up protecting the central bank and financial institutions from political and shareholder accountability more than preserving financial stability.

Please re-read the highlighted counters to the arguments against transparency.

For example, the Fed fought tooth and nail to resist Freedom of Information Act demands by two news media for disclosures relating to its emergency lending during and soon after the Crisis.

When disclosure was finally forced, the information proved very embarrassing for both domestic and foreign financial institutions and the Fed itself.

Had the Fed’s actions been known during the passage of the Dodd-Frank Act, different policy choices might well have been made, both regarding the support powers of the Fed and the permissible scale and operations of financial institutions.

Professor Baxter shows just how low hanging the fruit of transparency is and how the influence of the Blob prevents its being adopted.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.